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Roach Motel Economics

July 13, 2015 9:19 pmJuly 13, 2015 9:19 pm

So we have learned that the euro is a Roach Motel — once you go in, you can never get out. And once inside you are at the mercy of those who can pull your financing and crash your banking system unless you toe
the line.

I and many others have had a lot to say about the politics of this reality. But let me say a word about the economic implications for the euro area as a whole — which are basically that Europe has created a system
that treats surplus and deficit countries asymmetrically, even more than the classical gold standard, and leads to a severe deflationary bias.

This is true both for fiscal issues and for balance of payments issues. Debtors are forced into draconian austerity, while creditors face no pressure to reflate; economic crisis, which should be met with expansionary
policy, instead leads to contraction because of this asymmetry. Meanwhile, countries that find themselves overvalued are forced to deflate in an effort to regain competitiveness, while undervalued counties face
no pressure to help out with a higher inflation rate — so at times of major misalignment, when moderate inflation can help, the overall effect is declining inflation and maybe even deflation.

And we’re talking about huge costs here. Look at the crude Phillips curve I estimated for Greece a few days back, shown in the chart.

Photo

Credit

It suggests that it takes about 4 point-years of output gap to reduce prices relative to baseline by 1 percentage point. So suppose that you are 25 percent overvalued, and get no help from higher inflation in the core.
Then “internal devaluation” requires sacrificing around 100 percent of a year’s GDP. Let’s repeat that: given what we now know about the rules of the game, countries as overvalued as
much of the European periphery became thanks to the lending boom are supposed to sacrifice a full year’s economic output as part of a process of beating prices and wages down.